Excel Activity: Calculating the WACC

Here is the condensed 2021 balance sheet for Skye Computer Company (in thousands of dollars):

	2021
Current assets		$	2,000
Net fixed assets			3,000
Total assets		$	5,000
Accounts payable and accruals		$	900
Short-term debt			100
Long-term debt			1,500
Preferred stock (10,000 shares)			200
Common stock (50,000 shares)			1,125
Retained earnings			1,175
Total common equity		$	2,300
Total liabilities and equity		$	5,000

Skye's earnings per share last year were $2.65. The common stock sells for $50.00, last year's dividend (D₀) was $1.65, and a flotation cost of 12% would be required to sell new common stock. Security analysts are projecting that the common dividend will grow at an annual rate of 10%. Skye's preferred stock pays a dividend of $2.75 per share, and its preferred stock sells for $25.00 per share. The firm's before-tax cost of debt is 8%, and its marginal tax rate is 25%. The firm's currently outstanding 8% annual coupon rate, long-term debt sells at par value. The market risk premium is 4%, the risk-free rate is 5%, and Skye's beta is 1.504. The firm's total debt, which is the sum of the company's short-term debt and long-term debt, equals $1.6 million.

1. Calculate the cost of each capital component, that is, the after-tax cost of debt, the cost of preferred stock, the cost of equity from retained earnings, and the cost of newly issued common stock. Use the DCF method to find the cost of common equity.

After-tax cost of debt: 6.00%

Cost of preferred stock: 11.00%

Cost of retained earnings: 13.63%

Cost of new common stock: 14.13%

b. Now calculate the cost of common equity from retained earnings, using the CAPM method.

11.02%

3. What is the cost of new common stock based on the CAPM? (Hint: Find the difference between r_e and r_s as determined by the DCF method, and add that differential to the CAPM value for r_s.)

11.51%

d. If Skye continues to use the same market-value capital structure, what is the firm's WACC assuming that (1) it uses only retained earnings for equity and (2) if it expands so rapidly that it must issue new common stock? (Hint: Use the market value capital structure excluding current liabilities to determine the weights. Also, use the simple average of the required values obtained under the two methods in calculating WACC.)

WACC₁: ____________?????

WACC₂: ____________?????